There's a 'storm brewing' in the US economy

Lightning
flashes behind an air traffic control tower at McCarran
International Airport.Ethan
Miller/Getty Images

It could get ugly in the US economy before long.

While everyone has been distracted by the strong labor market and
the decent consumption, the real breakdown in the US economy has
been coming from the corporate sector, which is what Paul
Mortimer-Lee of BNP Paribas argues in a note titled "US Growth:
Storm Brewing?"

"Why have so many, including the Fed, not seen the risks that now
appear all too concrete?" asked Mortimer-Lee, chief US economist
at BNP.

"The answer is that they have been looking in the wrong
direction, lulled into a sense of complacency by strong jobs
growth and solid consumption. What this view has overlooked is
that the threat of recession comes from the corporate sector."

According to Mortimer-Lee, the drop in
profits in the corporate sector typically presages a
recession. In this case, the stagnant inflation has reflected an
inability of US companies to increase prices to the level
necessary to maintain profits while labor costs have been rising.

Said another way, companies are paying employees more, and they
can't hike prices to keep up with the rising cost. Thus,
profits fall. This increase, according to Mortimer-Lee, is
strikingly like the lead-in to the 2001 recession, which was
preceded by a drop in corporate profits.

"We believe that in an economy with a significant profit-oriented
private sector, the rate of profit and its dynamic is a key
determinant of the business cycle," Mortimer-Lee wrote.

"While some have argued that cycles don’t die of old age,
declining rates of profitability are often a sign that the
economy is very sick, no matter what the age of the recovery."

"But capex has been weak recently. Oil investment plays a part,
of course, but the bigger picture seems to us to be that
previously weaker corporate profitability as a share of GDP is
beginning to feed into weaker capex with a lag," Mortimer-Lee
wrote. "Frequently, such episodes do not end well."

Add that the stock market stumbles last August and at the
beginning of the year have made companies warier of financial
conditions and you've got a worrying number of clouds on the
horizon.

Thus, Mortimer-Lee projects that the risk of recession over the
next 12 months is somewhere between 40% and 50%, depending on how
terrible the incoming labor market data looks. This isn't a
majority, and thus not the most likely outcomes, but the
likelihood is certainly spiking in an uncomfortable direction.

"We will need to hang on to our hats, because it’s going to be a
bumpy ride," Mortimer-Lee wrote. "The risk of recession is
rising, though this is not currently our central case."